Can the Federal Reserve Prevent Deflation?

When most people talk about interest rates today, they realize the lowest rates can go is to zero. Consequently, they believe at present the bottom is almost in for interest rates and the only thing the future holds is higher inflation and interest rates. But since the economy has not yet recovered, what can the Fed do to stimulate the economy and thus prevent this deflationary credit contraction that’s presently occurring?

When Central Banks implement a zero-rate interest policy, they know that if they implemented negative returns, individuals would resort to hoarding the currency. The last thing a bank wants is to have its depositors take all their cash out and put it under their mattress to prevent losing money by keeping it in the bank and earning negative returns.

While the Japanese (2003) and Swiss (2009) have flirted with negative interest rates in the last decade, they have been short lived attempts at stimulating lending by the banks.

The Federal Reserve is presently following the Bank of Japan’s example in trying to stimulate the economy. In fact, the interest rate on the 3-month treasury bill is now lower than the Japanese 3-month Yen rate as seen in the following charts.

3-month Treasury Bill Rate;  JP 3-month Yen rate

While interest rates are at historic lows, they have done nothing to stimulate the economy in Japan since 1989. The U.S. meanwhile is just at the beginning of their unwinding of the excesses during the inflationary boom.

Instead of experiencing a long drawn out no-growth period ala Japan, Bernanke and the Fed have decided to combat this deflationary trend with a massive influx of stimulus to banks and businesses, Freddie and Fannie and anyone with a business pulse, including cash for clunkers, caulkers, appliances and environmental companies to the tune of $1.4 trillion in 2009 and on pace to surpass that record amount in 2010.

The problem is, even though the 2010 spending isn’t over with, the stimulus hasn’t worked.

Millions are still unemployed as the numbers haven’t improved by much (real unemployment rates are 16% – 20% depending on which calculation one utilizes). The only real improvement has been in government related jobs. Prices are falling and the Fed’s bag of tricks is running on empty. This is because their options are limited by the Federal Reserve Act of 1934.

The Fed is limited per the Act as to what they can purchase in their attempts to stimulate.

Private-Sector Assets Eligible and Ineligible

for Purchase by the Federal Reserve

2. There is No Express Authority for the Federal Reserve to Purchase:

• Corporate Bonds
• Commercial Paper
• Mortgages
• Equity
• Land (Other that Federal Reserve premises)

2. The Federal Reserve May Purchase

• Gold*
• Foreign Exchange
• Bankers’ Acceptances
• Bills of Exchange

Subject to:

Restriction 1.

Purchases of foreign exchange, bankers’ acceptances, and bills of exchange are to be in the open market.

Restriction 2.

In usual circumstances the bills of exchange must meet the \real bills” doctrine but, it seems, bankers’ acceptances do not.

In “unusual and exigent” circumstances the types of bills of exchange that are eligible to be purchased are open to interpretation.

* Subject to the Gold Reserve Act of 1934.

Of course the Fed can lend directly too, or in the case of a few companies, (AIG and GM), just take them over.

But since they are limited in scope, and without just “raining money” on people, there should be no worries for anyone. Congress has given the Fed even more tools to stimulate the economy in the coming years by giving them more power under the Restoring American Financial Stability Act of 2010 (I can hear you cheering now!).

From the Act:

TITLE XI—FEDERAL RESERVE SYSTEM PROVISIONS
Sec. 1151. Federal Reserve Act amendments on emergency lending authority.
Sec. 1152. Reviews of special Federal reserve credit facilities.
Sec. 1103. Public access to information.
Sec. 1104. Liquidity event determination.
Sec. 1105. Emergency financial stabilization.
Sec. 1106. Additional related amendments.
Sec. 1107. Federal Reserve Act amendments on Federal reserve bank governance.
Sec. 1108. Amendments to the Federal Reserve Act relating to supervision and regulation policy.

Bernanke and his cronies must be drooling like a pack of wolves waiting to get at the sheep once that gate is unlocked bill is passed. But what Congress in their usual ineptness never considers, is what has the Fed ever got right since Nixon took us off the gold standard in 1971? Did they forget already the Savings and Loan crisis? The Asian crisis? The stock market bubble? The real estate bubble? The banking crisis today?

If the Federal Reserves mandate is stable prices and full employment, and they have failed at obtaining these, what will giving them more power to effect “change” do for us?

Switzerland: A Shining Example of How To Do Things Right

Why do the Swiss historically have a better economy, growth, lower inflation, lower  unemployment, low interest rates, a higher GDP per capita and a stronger currency?

Look at the differences in the next two charts to see how stability has been accomplished in Switzerland.

Looking at this from a different perspective shows even further what stability can mean. The U.S. Dollar Index above paints the picture of how the U.S. Dollar has performed versus a basket of currencies outlined below.

The Dollar Index is computed using a trade-weighted average of the following six currencies:

• Euro 57.6 %
• Japan/Yen 13.6 %
• UK/Pound 11.9 %
• Canada/Dollar 9.1 %
• Sweden/Krona 4.2 %
• Switzerland/Franc 3.6 %

The index was introduced in 1973 with a base of 100 and incorporated the Euro when it was introduced in 1999.

The Swiss Franc only represents 3.6% of that Dollar Index, so a better way to compare the U.S. Dollar and the Swiss Franc is to price both in gold as the following chart does.

The Swiss Franc, and its stable economy, has outperformed the U.S. dollar, priced in gold, by 50% the last 10 years.

Part of the reason the Swiss economy has historically remained stable of course is the fact they don’t get involved in fighting wars. Their economy hasn’t had to outlay over a trillion dollars to fight two wars in the last decade.

Back To Interest Rates; Did the Swiss Offer Negative Interest Rates?

The answer is yes, and I’m not talking about the short stint of negative rates offered by banks in 2009.

Switzerland saw their currency, the Swiss franc, appreciate 28% versus the U.S. dollar. in just 6 months from Dec. 1972 to July 1973 as seen in the following chart. (click for sharper image)

Because of the rush to the Swiss currency, the Swiss National Bank implemented a policy of -10% interest rates a quarter to make their currency weaker. This resulted in an appreciation of 27% for the USD over the next six months.

But as you can see from the chart, the downtrend resumed and six months later, was back where it started.

To put this into perspective, Nixon took us off the gold standard Aug. 15, 1971. The Swiss franc was at 4.00 to the dollar at that time. Before the 28% appreciation to the U.S. dollar, it had already risen 6.25%. My speculation is this was because of the fact everyone knew the Swiss had a lot of gold in reserve.

Because the Swiss held so much gold in reserves, many people thought the Swiss franc was backed by gold. It of course wasn’t, but the perception still lingers. In fact, the Swiss were forced to sell much of their gold at a time when the price of gold was rising during the last two Central Bank Agreements. I can’t imagine the Swiss citizens have been too happy about that!

How would you feel if the U.S. government sold all “our” gold? (This is the part where the astute reader says…”what gold?”)

The important point here is to contemplate what “perception” can do for a currency.

Despite all of the monetary stimulus the Fed has been pumping into the system, just before this latest stumble in the dollar, the dollar had been appreciating versus the basket of currencies mentioned above. The latest decline is the result of a rebound in the Euro and some further strength in the Yen. This won’t last.

While the U.S. has its issues, the Euro has their banking issues and the Yen is backed by the highest Debt to GDP ratio in the world, more than twice that of the U.S.

The perception of the U.S. dollar the world over is still one of strength. Looking at the long term Dollar Index chart above, it is still above the 80 trend-line, which has only been broken twice since we went off the gold standard. It’s flirting with it again, but I view this as psychological support.

The fact that the Yen, despite the high debt to GDP ratio can perform well during their deflationary episode shows that it is “faith” in the currency that matters most. This faith can only last so long and for the U.S. Dollar, 70% of the world still have faith in it versus all other currencies. There is no logical reason for this but that’s the way it is. Perhaps its our military might or the threat thereof that keeps it from capitulating from the over $13 trillion of debt hanging over it.

Can The Fed Prevent Deflation?

So while the Fed has thus far failed in its attempt to stimulate the economy by  dumping a few more trillion into the economy through the entities mentioned above, they will no doubt keep trying to come up with new ways to get the economy going. But the Fed cannot force businesses and consumers to take on more debt. So while the banks aren’t loaning as they concentrate on improving their own balance sheets, deflation is weeding out the bad debt and returning things to where they ought to be. Deflation is a good thing. Prices come down. Debt is paid off or defaulted upon. Purchasing power increases. The bottom is put in. Growth returns.

But the Fed doesn’t understand this natural phenomenon.They have to stimulate and stimulate they will. They had a special way of solving things back in the 1929-1933 deflationary era as seen in the following chart.